A 1031 improvement exchange is one of many types of 1031 exchanges that follow the same strict rules defined in Internal Revenue Code Section 1031. A 1031 exchange enables the Taxpayer to defer federal and state capital gain and depreciation recapture taxes when selling and replacing real and personal property held in the productive use of a business or for investment. Real property can only be replaced with real property while personal property must be exchanged for like-kind or like-class personal property. Property predominantly located in the US is only exchangeable for property held predominantly in the US. Foreign real and personal property are eligible for the tax deferral if exchanged for real and personal property held predominantly outside the US.
As the velocity of real estate sales picks up, questions surface regarding how best to repair the replacement properties in a 1031 exchange. There are two acceptable strategies and one not acceptable strategy. Before reading more, for those not familiar with a 1031 exchange and you are selling real or personal property held in a business or for investment, continue to press forward. In the era of tax deferrals or for those who wish to minimize their tax bill, learn now, rather than when your accountant asks if you are familiar with a 1031 exchange, when it may be too late.
When a taxpayer plans to include improvements to be constructed in a 1031 exchange, the role of the Qualified Intermediary (QI) is extremely important. The Exchange Accommodator Titleholder (EAT) will hold the title to the property while the QI holds the cash included in the transaction while improvements are being made. The QI will then pay the vendors and contractors, and prior to the 180th calendar day post-closing on the old or new property, the EAT will convey title to the taxpayer.
A 1031 construction exchange enables the taxpayer to defer federal and state capital gains and recapture depreciation taxes on the sale of existing property, and construct improvements to a replacement property. In what is known as a 1031 tax deferred exchange, a construction exchange of equal or greater value to the old or relinquished property is quite common.
Hotel owners can adjust their portfolios by replacing underperforming assets through the use of a 1031 improvement exchange-strategy. According to the Internal Revenue Code Section 1.1031, 1031 exchange allows no gain to be recognized when property held for productive use in business or for investment is exchanged for like-kind property held for productive use in business or for investment. With the 1031 improvement exchange, hotel owners sell an existing hotel to acquire a hotel, renovating the new property while deferring the federal and state capital gains and recaptured depreciation tax.
Improving a foreclosure, constructing improvements or building on raw land are common transactions in the current 1031 tax deferred exchange market. The capital gain deferral benefit allows sales proceeds to be used towards making improvements to the replacement property. Each 1031 construction exchange has in common the sale of an old property and the acquisition of a new property.
A 1031 improvement exchange defers capital gains from the sale of property while making improvements to a replacement property. 1031 tax deferred exchanges allow for federal and state capital gain and recaptured depreciation taxes to be deferred given the real property is held for use in a business or investment and replaced with real property held for use in a business or investment. A 1031 exchange defers upwards of 40% of the sale price of the old property representing an interest free loan to use those proceeds towards purchasing new property.
A build to suit or improvement 1031 exchange uses exchange proceeds to improve the replacement property. A typical build to suit is when real property is sold and replaced with land and improvements. The key is timing, given only those improvements fixed to the ground by the 180th calendar day post closing represent the value of capital gains deferred. Prepare to begin construction the day following the purchase of the replacement property to maximize percentage complete.